If you are thinking of buying or selling a business, one of the most important questions you need to answer is: How much is the business worth?
Business valuation for buy and sell is the process of estimating the economic value of a business or a business unit. It can help you determine the fair price to pay or receive for a business, as well as the potential return on investment.
There are many methods and factors that can be used to value a business, depending on the purpose, nature, and industry of the business.
In this post, we will discuss some of the most common and widely used methods of business valuation for buy and sell, as well as some tips and best practices to follow when valuing a business.
Market Capitalization
Market capitalization is the simplest and most straightforward method of business valuation for buy and sell. It is calculated by multiplying the company’s share price by its total number of shares outstanding.
For example, as of January 3, 2018, Microsoft Inc. traded at $86.35. With a total number of shares outstanding of 7.715 billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion.
This method is only applicable to publicly traded companies, as their share prices are readily available and reflect the market’s perception of their value.
However, this method does not take into account the company’s assets, liabilities, growth prospects, or competitive advantages. It also assumes that the market is efficient and rational, which may not always be the case.
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Earnings Multiplier
Earnings multiplier is another common method of business valuation, especially for privately held companies. It is based on the idea that the value of a business is proportional to its earnings potential.
To calculate the value of a business using this method, you need to multiply its earnings by a certain factor, known as the earnings multiplier or the price-to-earnings (P/E) ratio.
The earnings multiplier can vary depending on the industry, size, growth rate, risk, and profitability of the business. For example, a high-growth technology company may have a higher earnings multiplier than a low-growth manufacturing company.
The earnings multiplier can also be derived from comparing similar businesses in the same industry or market.
There are different ways to measure earnings for this method, such as net income, operating income, or seller discretionary earnings (SDE). SDE is the most commonly used measure for small businesses, as it reflects the true earning power of the business by adding back non-operating expenses and owner’s compensation to net income.
For example, suppose you want to value a small online retail business that has an annual net income of $100,000 and an annual owner’s salary of $50,000.
The SDE would be $100,000 + $50,000 = $150,000. If you assume that the average earnings multiplier for similar businesses in the same industry is 3x, then the value of the business would be $150,000 x 3 = $450,000.
Asset-Based Valuation
Asset-based valuation is another method of business valuation that focuses on the company’s assets and liabilities.
It is calculated by subtracting the total liabilities from the total assets of the company. The assets can include both tangible assets (such as cash, inventory, equipment, and real estate) and intangible assets (such as patents, trademarks, goodwill, and customer relationships).
This method is often used for businesses that have significant assets or are in liquidation or distress situations.
However, this method does not consider the earning potential or future growth of the business. It also may not reflect the fair market value of some assets or liabilities, as they may be recorded at historical cost or book value rather than current market value.
For example, suppose you want to value a manufacturing company that has total assets of $1 million and total liabilities of $500,000. The asset-based valuation would be $1 million – $500,000 = $500,000.
However, this may not accurately represent the company’s value if some of its assets are obsolete or overvalued or some of its liabilities are understated or contingent.
Discounted Cash Flow (DCF) Valuation
Discounted cash flow (DCF) valuation is one of the most sophisticated and comprehensive methods of business valuation for buy and sell. It is based on the idea that the value of a business is equal to the present value of its future cash flows.
To calculate the value of a business using this method, you need to project its future cash flows for a certain period (usually 5 to 10 years) and then discount them back to today using an appropriate discount rate.
The discount rate reflects the risk and opportunity cost of investing in the business. It can be estimated using various models, such as the capital asset pricing model (CAPM) or the weighted average cost of capital (WACC). The discount rate can also be adjusted for the specific risk factors of the business, such as industry, size, growth, and profitability.
The DCF valuation method is often used for businesses that have stable and predictable cash flows, as well as high growth potential.
However, this method requires a lot of assumptions and estimates, which can introduce a lot of uncertainty and error. It also depends on the accuracy and reliability of the financial data and projections used.
For example, suppose you want to value a software company with an annual free cash flow of $200,000, which is expected to grow at 10% per year for the next 10 years.
If you assume that the discount rate is 15%, then the value of the business would be:
$200,000 x (1 – 1.1^10 / 1.15^10) / (0.15 – 0.1) = $1,026,839
Comparable Company Analysis
Comparable company analysis is another method of business valuation for buy and sell that relies on comparing similar businesses in the same industry or market. It is based on the idea that the value of a business is influenced by the value of its peers or competitors.
To calculate the value of a business using this method, you need to identify a set of comparable companies and use their valuation multiples to estimate the value of your target company.
Valuation multiples are ratios that relate the value of a company to some measure of its financial performance or position, such as revenue, earnings, assets, or equity. Some of the most common valuation multiples are:
- Price-to-sales (P/S) ratio: The market value of a company divided by its annual sales.
- Price-to-earnings (P/E) ratio: The market value of a company divided by its annual earnings.
- Enterprise value-to-EBITDA (EV/EBITDA) ratio: The enterprise value (market value plus net debt) of a company divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA).
- Enterprise value-to-sales (EV/S) ratio: The enterprise value of a company divided by its annual sales.
The valuation multiples can vary depending on the industry, size, growth rate, risk, and profitability of the companies.
The valuation multiples can also be derived from analyzing historical transactions or deals involving similar businesses in the same industry or market.
For example, suppose you want to value a restaurant chain that has an annual revenue of $10 million and an annual EBITDA of $2 million.
If you assume that the average EV/EBITDA multiple for similar businesses in the same industry is 8x, then the value of the business would be:
$2 million x 8 = $16 million
Rule of Thumb Valuation
Rule of thumb valuation is another method of business valuation that uses general guidelines or formulas to estimate the value of a business.
It is based on the idea that there are some common patterns or trends in how businesses are valued in different industries or markets.
To calculate the value of a business using this method, you need to apply a specific rule of thumb that is relevant to your type of business.
Rule of thumb valuation can be useful for getting a quick and rough estimate of the value of a business. However, this method may not be very accurate or reliable, as it does not take into account the specific characteristics or circumstances of each business. It also may not reflect the current market conditions or trends.
Some examples of the rule of thumb valuation are:
- A retail store is worth 30% to 50% of its annual sales plus inventory.
- A professional service firm is worth 1x to 3x its annual gross revenue.
- A dental practice is worth 60% to 80% of its annual collections.
- A landscaping business is worth 2x to 4x its annual net income.
Conclusion
Business valuation is a complex and dynamic process that requires careful analysis and judgment. There is no one-size-fits-all method or factor that can provide a definitive answer to the question: How much is the business worth?
Therefore, using multiple methods and factors to cross-check and validate your valuation results is important.
Whether you are buying or selling a business, you need to understand the purpose and context of your valuation, gather reliable and relevant data and information, adjust for non-recurring or extraordinary items, and apply the appropriate methods and factors that suit your type of business. By doing so, you can ensure that you are paying or receiving a fair price for the business and maximizing your return on investment.